Are Two Euros Better than One? (Published May 9, 2010)

The difficulties of life often push apart even the most loving couples. When differences of opinion become incurable, it serves no purpose to remember the love that was. Trying to attribute responsibility for the failure of the relationship is counterproductive. It only makes things worse. It’s better to come to an amicable separation and, as the English say, move on.

This same concept applies to the euro. It was a love marriage. Against the pessimism of the intellect, the founding fathers advanced the optimism of the will: the hope (delusion?) that the obvious incompatibilities would be overcome in the process of integration. To those (American economists) who said that the euro are was not made to have a single currency, they retorted that they were speaking out of envy, or worse, for fear that the euro would one day supplant the dollar.

As with many couples, the fatal attraction was born of differences. Southern Europe was looking for an external engagement that would give them the monetary and fiscal discipline that they had not been able to achieve alone.

Northern Europe hoped that in marriage the South would put its head on straight and abstain from the continuous devaluations that created tensions on the foreign exchange and export markets. As with many couples, these differences, so attractive initially, have become unsustainable over time.

Economic theory suggests that to share the same currency a geographical area must satisfy two conditions. The first is that it has a relatively homogenous economy, subjected to the same shocks. If part of the economy relies on oil and part on high tech, shocks will be very different, and monetary policy that fits one area will not work in the other.

The second condition, even more important, is internal mobility. If Texas (traditionally an oil-driven economy) can coexist with California (mostly relying on high tech), it is because Californians can easily move to Texas and vice versa. So much so that Austin, Texas has become one of the capitals of personal computers.

This is not true for Europe. It’s not just that the economy of the North of Europe, mainly based on the advanced manufacturing industry, is very different from that of the South, which is based on tourism, but mobility is very limited. What little mobility that exists is from the South to the North, not vice versa.

Since the introduction of the euro, the South has seen prices increasing at a faster rate than the North. Paradoxically, this growth was the euro’s “fault.” The introduction of a single currency resulted in a reduction in interest rates for the countries of southern Europe that favored a real estate boom. If this had been in the United States, residents of Michigan and Minnesota would be moving to Florida and Louisiana. This was not the case in Europe. The Germans and the Dutch in Greece and Spain are there to vacation, not to work.

The result of this segmentation is that for many years, prices in southern Europe have grown more than in the North, without the domestic markets forcing realignment. Now that the real estate boom has ended, the South is much less competitive than the North.

Without the option of devaluation, there are only three possible forms of adjustment. The first is to make prices in the South grow less than prices in the North. The problem with this is that with low global growth and the ECB’s monetary policy, prices in the North hardly grow more than two percent.

To recoup differentials of 20-30% (as they have in the southern markets), the South must undergo many years of zero inflation, or worse, deflation. The high levels of private debt in countries such as Greece and Spain, however, makes deflation extremely costly. If prices fall and debt remains fixed in nominal terms, there will be a chain of failures. The Greek government crisis “ce n’est qu’un début”: the problem will quickly move to the private sector.

An alternative is for the countries of the North to accept a higher inflation level, making it possible for the southern countries to regain competitiveness without having to accept a dangerous deflation. But this is the equivalent of asking a spouse to no longer be themselves in order to save the marriage. The Germans will not accept this. Their condition for joining was that the ECB would follow the strict monetary policy of the Bundesbank. This agreement has been incorporated into the treaties and is unlikely to be changed, especially without Germany’s consent. And the Germans do not see why they should have to accept much-despised inflation to correct the mistakes of others.

The only painless way out would for southern Europe to gain competitiveness with respect to the North and increase productivity. But this would require reforms, time, and investment. While the impact of the Greek crisis may have increased the pressure for reform, it has dramatically reduced the time available and the incentives to invest. How many years of double-digit unemployment are the Greeks and Spanish willing to bear?

Most economists accept this analysis, even Nobel Laureate Stiglitz, who certainly cannot be accused of being a right-wing economist. Where they disagree is in the remedy. Many, including Stiglitz, argue that the solution to the present crisis is further political and fiscal integration. Of course if the European government itself could borrow and allocate resources to the South, the current crisis could be alleviated.

This reasoning is correct, but it raises two major problems. The first is political. Politically it is not easy to explain to the Germans that they need to take on more debt (and therefore pay higher taxes in the future) to solve their Greek and Spanish cousins’ problems. It cannot be done in an electorally weak and divided government like Merkel’s. And it probably would not be possible even in the government of the best German leader.

We Italians live in a country that speaks the same language and that, for better or worse, united more than 150 years ago and is moving towards fiscal federalism, which will contribute to a reduction in transfers from the North to the South. How can we expect the European nations to go in a completely opposite direction, even while lacking a unified history?

The second problem is economic. Transfers alleviate economic problems in the short term, but do not solve them. Indeed, they will become chronic. Thanks to subsidies, areas not in line with the market can afford to remain so, without adjusting prices. The South of Italy has a price level higher than its average productivity. Sixty years of transfers have not alleviated this problem, but have turned it into gangrene. Do we want to transform the South of Europe into southern Italy?

The only solution left is to accept that the differences are irreconcilable and amicably break up the euro area. In economics, the greatest evil is uncertainty. The Greek crisis has sown the seed of doubt that one or more countries could leave the euro. Such doubt can hardly be dispelled. But the market has no idea how this exit will occur. Overwhelmed by passionate love, the euro’s founders refused to contemplate a way out. The euro, they said, is irreversible. But even the Catholic Church, which does not recognize divorce, has a procedure for separation in extreme situations. Why not for the euro?

This lack of rules is casting panic into the financial markets and paralyzing investment. Who will leave first? What will happen to contracts processed in euros in that country? What consequences will it have on other countries and their banks? A driven and rapid separation would be the lesser evil.

Creating two blocks would reduce the stigma on each country and allow the South to continue to hold a liquid currency. The euro-south’s depreciation against the euro-north would reduce the weight of public and private debt and allow a recovery of competitiveness that would relaunch the economy.

Is this inconceivable? Even the United States did this in the 30s, in the face of economic and social costs arising from the Great Depression, the United States abandoned the gold standard and turned all contracts written in dollar-gold to contracts in devaluated paper dollars. Why shouldn’t the southern European states abandon parity with the euro and transform contracts written in euros into contracts in a devalued euro-south?

A legitimate passion for European unity blinded the founding fathers of the euro. Like two lovers who hope that marriage will eliminate all their faults, the founding fathers were under the delusion that the European Union would create the European spirit. Indeed, the free movement of people, the Erasmus scholarships, and the increasingly widespread use of English are slowly forming a European spirit.

But it will take many decades, even centuries, before a Finnish citizen views a Greek citizen in the same way as their neighbor. More than a millennium of division is not erased in the space of a decade. A compulsory union does not help the economy or even the possibility of a future union. To save the European spirit it’s better to divorce amicably, which would preserve the economic union without forcing the monetary union. The alternative, an endless stream of bickering and recriminations, could be devastating.